Corporate Finance

1. Corporate Finance Lecture 8

2. Announcements • 2nd quiz • Opens at midnight tonight • Valid for 48 hours • Closes at midnight of Thursday • 2nd case : Boeing 7E7 • Questions will be posted on May 8 • Delivery deadline: May 13 • Discussion: May 15

3. Topics covered • MM proposition without tax • MM proposition with tax • Cost of financial distress • Direct cost • Indirect cost • Reducing cost of debt • Integration of tax benefit and financial distress cost of debt

4. Modigliani and Miller (MM) Proposition (no taxes) • Proposition I • Firm value is not affected by leverage VL = VU • Capital structure does not change firm value

5. Assumptions of the Modigliani-Miller Model • Homogeneous Expectations • Homogeneous Business Risk Classes • Perpetual Cash Flows • Perfect Capital Markets: • Perfect competition • Firms and investors can borrow/lend at the same rate • Equal access to all relevant information • No transaction costs • No taxes

6. EPS and ROE Under Both Capital Structures All-EquityRecession Expected Expansion EBIT $1,000 $2,000 $3,000 Interest 0 0 0 Net income $1,000 $2,000 $3,000 EPS $2.50 $5.00 $7.50 ROA 5% 10% 15% ROE 5% 10% 15% Current Shares Outstanding = 400 shares LeveredRecession Expected Expansion EBIT $1,000 $2,000 $3,000 Interest 640 640 640 Net income $360 $1,360 $2,360 EPS $1.50 $5.67 $9.83 ROA 5% 10% 15% ROE 3% 11% 20% Proposed Shares Outstanding = 240 shares

7. Homemade Leverage:An Example Recession Expected Expansion EPS of Levered Firm $1.50 $5.67 $9.83 Earnings for 24 shares $36 $136 $236

8. B $ 800 2 = = 3 S $ 1 , 200 Homemade Leverage:An Example Recession Expected Expansion EPS of Unlevered Firm $2.50 $5.00 $7.50 Earnings for 40 shares $100 $200 $300 Less interest on $800 (8%) $64 $64 $64 Net Profits $36 $136 $236 ROE (Net Profits / $1,200) 3% 11% 20% Buying 40 shares of a $50 stock, we get the same ROE as if we bought into a levered firm. Our personal debt equity ratio is:

9. The MM Propositions II (No Taxes) • Proposition II • Leverage increases the risk and return to stockholders rs = r0 + (B / SL) (r0 - rB) rB is the interest rate (cost of debt) rs is the return on (levered) equity (cost of equity) r0 is the return on unlevered equity (cost of capital) B is the value of debt SL is the value of levered equity

10. B S = Then set r r = ´ + ´ r r r WACC 0 WACC B S + + B S B S + B S B S ´ + ´ = r r r multiply both sides by B S 0 + + B S B S S + + + B S B B S S B S ´ ´ + ´ ´ = r r r 0 B S + + S B S S B S S + B B S ´ + = r r r B S 0 S S B B B = + - r r ( r r ) ´ + = + r r r r 0 0 S B 0 0 B S S S S The MM Proposition II (No Taxes) The derivation is straightforward:

11. B S MM Proposition II with No Corporate Taxes Cost of capital: r (%) r0 rB rB Debt-to-equity Ratio

12. Shareholde rs in a levered firm receive Bondholder s receive - ´ - ( EBIT r B ) ( 1 T ) r B B C B Thus, the total cash flow to all stakeholde rs is - ´ - + ( EBIT r B ) ( 1 T ) r B B C B - ´ - + = ( EBIT r B ) ( 1 T ) r B B C B = ´ - - ´ - + EBIT ( 1 T ) r B ( 1 T ) r B C B C B = ´ - + EBIT ( 1 T ) r BT C B C \ = + V V T B L U C The MM Proposition I (Corp. Taxes) The present value of this stream of cash flows is VL The present value of the first term is VU The present value of the second term is TCB

13. = + V V T B L U C = + Þ + = + V S B S B V T B L U C = + - V S B ( 1 T ) U C The MM Proposition II (Corp. Taxes) Start with M&M Proposition I with taxes: Since The balance sheet of a levered firm can be written as

14. + = + Sr Br V r T Br 0 S B U C B + = + - + Sr Br [ S B ( 1 T )] r T r B 0 S B C C B B B B + = + - + r r [ 1 ( 1 T )] r T r 0 S B C C B S S S B = + ´ - ´ - r r ( 1 T ) ( r r ) 0 0 S C B S The MM Proposition II (Corp. Taxes) The cash flows from each side of the balance sheet must equal: Divide both sides by S Which reduces to

15. The Effect of Financial Leverage on the Cost of Debt and Equity Capital with Corporate Taxes Cost of capital: r(%) r0 rB Debt-to-equityratio (B/S)

16. Total Cash Flow to Investors Under Each Capital Structure with Corp. Taxes All-EquityRecession Expected Expansion EBIT $1,000 $2,000 $3,000 Interest 0 0 0 EBT $1,000 $2,000 $3,000 Taxes (Tc = 35% $350 $700 $1,050 Total Cash Flow to S/H $650 $1,300 $1,950 LeveredRecession Expected Expansion EBIT $1,000 $2,000 $3,000 Interest ($800 @ 8% ) 640 640 640 EBT $360 $1,360 $2,360 Taxes (Tc = 35%) $126 $476 $826 Total Cash Flow $234+640 $468+$640 $1,534+$640 (to both S/H & B/H): $874 $1,524 $2,174 EBIT(1-Tc)+TCrBB $650+$224 $1,300+$224 $1,950+$224 $874 $1,524 $2,174

17. Tax effect of debt • In a world without taxes, debt does not affect firm value. • When there are corporate taxes, the firm value is positively related to its debt --Debt reduces the firm’s tax liability • With taxes, the sum of the debt plus the equity of the levered firm is greater than the equity of the unlevered firm.

18. Total Cash Flow to Investors All-equity firm Levered firm S G S G B This is how cutting the pie differently can make the pie larger: the government takes a smaller slice of the pie!

19. Costs of financial distress • Direct costs: Legal and administrative costs • Indirect costs: • Impaired ability to conduct business • Agency costs: conflicts between the shareholders and the debtholders • Incentive to take large risks • Incentive toward underinvestment • Milking the property

20. Balance Sheet for a Company in Distress Assets BV MV Liabilities BV MV Cash $200 $200 LT bonds $300 Fixed Asset $400 $0 Equity $300 Total $600 $200 Total $600 $200 What happens if the firm is liquidated today? $200 $0 The bondholders get $200; the shareholders get nothing.

21. $100 NPV = –$200 + (1.50) Selfish Strategy 1: Take Large Risks The Gamble Probability Payoff Win Big 10% $1,000 Lose Big 90% $0 Cost of investment is $200 (all the firm’s cash) Required return is 50% Expected CF from the Gamble = $1000 × 0.10 + $0 = $100 NPV = –$133

22. $30 $70 $20 = $47 = (1.50) (1.50) Selfish Stockholders Accept Negative NPV Project with Large Risks • Expected CF from the Gamble • To Bondholders = $300 × 0.10 + $0 = $30 • To Stockholders = ($1000 – $300) × 0.10 + $0 = $70 • PV of Bonds Without the Gamble = $200 • PV of Stocks Without the Gamble = $0 • PV of Bonds With the Gamble: • PV of Stocks With the Gamble: • Debtholder expropriation by shareholders

23. $350 NPV = –$300 + (1.10) Selfish Strategy 2: Underinvestment • Consider a government-sponsored project that guarantees $350 in one period • Cost of investment is $300 • the firm only has $200 now • the stockholders will have to supply an additional $100 to finance the project • Required return is 10% NPV = $18.18 Should we accept or reject?

24. Selfish Strategy 2: underinvestment

25. Selfish Strategy 2: Underinvestment

26. Selfish Strategy 3: Milking the Property • Liquidating dividends • Increase perquisites to shareholders and/or management

27. Protective Covenants • Agreements to protect bondholders • Negative covenant: • Pay dividends beyond specified amount. • Sell more senior debt & amount of new debt is limited. • Positive covenant: • Maintain good condition of assets. • Provide audited financial information. • Working capital requirement.

28. Integration of Tax Effectsand Financial Distress Costs Value of firm underMM with corporatetaxes and debt Value of firm (V) Present value of taxshield on debt VL = VU + TCB Present value offinancial distress costs Maximumfirm value V = Actual value of firm VU = Value of firm with no debt 0 Debt (B) Optimal amount of debt B*

29. The Pie Model • VT = S + B + G + L • Marketed claims: VM = S + B • Nonmarketed claims: VN = G + L S B G L

30. Signaling • The firm’s capital structure is optimized where the marginal subsidy to debt equals the marginal cost. • Investors view debt as a signal of firm value. • A manager that takes on more debt than is optimal in order to fool investors will pay the cost in the long run.